Stocks rise slightly to start the week to start the week off in positive territory. The S&P500 gained 0.1% to 2,051 and the Dow Jones also rose 0.1% 17,623. The VIX fell to a notable low of 13.88 as volatility in US equities continues to fall. In China, the Shanghai Composite also rose after the PBoC eased restrictions on leveraged investments. Investing on margin for retail investors was a large factor that fueled the surge and subsequent collapse in China’s equity prices last summer. That type of lending was restricted in the aftermath of the stock market collapse, however today the PBoC eased those restrictions. This provided support for equity prices, which may have been the PBoC’s goal. Oil prices experienced a volatile session, with Brent finally closing 0.8% higher at $41.54. The US dollar index rose 0.2% to 95.35. The dollar rose against the euro to $1.1242 and 0.3% against the yen to Y111.86. Gold prices fell along with the dollar’s strength. Yields rose in the US after a sharp rally in Treasury prices last week. The 30 year rose 5 basis points to 2.72% and the ten year rose 5 basis points to 1.92%.
In the past companies seeking to acquire other companies have used junk bonds to finance such transactions, however given current market trends and regulatory constraints banks are backing away from this type of lending. In particular Credit Suisse, Jefferies, and Wells Fargo have backed away from backing leveraged buyouts. In a typical LBO transaction the banks guarantee the financing for the company before selling it to investors, however given the market turmoil and uncertainty in the current landscape this becomes an increasingly risky endeavor. The investor appetite for junk bonds is severely lacking which would leave banks with the option of selling bonds at a loss or keeping the high yielding junk bonds on their balance sheets. As a result of this change in risk appetite for banks LBO transactions have slowed 21% from last year as the supply of funds has decreased. Banks in the last year have struggled to sell the bonds of such deals and currently still hold tens of billions of dollars of exposure on their balance sheets.
The unprecedented fall in oil prices since 2014 has erased $150bn of value in companies from the energy sector. During this same time period $2.3tn has been taken from equity valuations. These losses reflect the financial impact of falling oil prices on energy companies, as well as the finance companies with exposure to the sector. As a result of the decline in bond value banks have been forced to accept losses on loans to energy companies. These losses and increasing financial strain come after the size of oil company total debt nearly tripled from $1.1tn in 2006 to $3tn in 2014. As a result of this increasing leverage leading up to a collapse in oil prices, many analysts expect defaults to increase in the sector. While falling oil prices may benefit the US economy in the long term, so far the most immediate effect to be seen is the added volatility in stock and bond markets. European banks in particular have significant exposure with a total of $200bn of outstanding energy loans for the region’s 20 largest banks.
TIPS bonds have surged in the last week in the aftermath of the FOMC meeting. From the Fed’s statement analysts interpreted that the Fed is more willing to let inflation drift upwards, effectively overshooting the 2% target by buying time to determine the global risks to the economy. As a result investors expect that the Fed is more willing to let inflation drift higher. At the same time oil prices have found support in the high $30 low $40 range, which eliminates one of the main headwinds to rising inflation. Since the Fed’s meeting 10 year TIPS prices have risen 1.7% and the yield has fallen to 0.26% which is the lowest level in the last year. With yields on TIPS falling relative to standard Treasury bonds, breakeven rates are on the rise. The ten year breakeven rate has risen to 1.62%, the five year is at 1.52%, and the two year is at 1.64%. These changes in market sentiment come after economic data has showed that inflation is building. Core inflation has risen to 2.3% and has beat expectations for two straight months. These signs, along with a dovish Fed are resulting in increasing inflation expectations, especially in the short term.